Bill Gross: Credit Supernova And Inflationary Dragons

At first glance, this article's title might make one think they are going to read about a sci-fi movie being released by Hollywood. Unfortunately, this is not the case. These two colorful terms -- "credit supernova" and "inflationary dragons" -- come to us from Bill Gross, the founder and managing director of PIMCO. In his last two investment outlook articles, he made some very concerning observations and warnings. As the current markets flirts with all-time highs, Gross is looking beyond the here and now. As he looks toward the future, what he sees looming on the horizon cannot simply be ignored as mere speculation.

Credit Supernova

In February 2013, Gross published an article titled "Credit Supernova!" This write-up provides a unique overview of credit and how it has been used over time to fuel modern-day economies. I find the term "supernova" to be a rather appropriate description to characterize the current situation that we find ourselves in. In the article, credit is described asa "monster that requires perpetually increasing amounts of fuel, a supernova star that expands and expands, yet in the process begins to consume itself."

Inflationary Dragons

The term "inflationary dragons" comes from Gross in his January 2013 article titled "Money for Nothin' Writing Checks for Free." Gross basically articulates to his readers that there is a price to pay when the U.S. government uses its printing press to produce as many U.S. dollars as it wishes. The article is best summed up by the following statements:

The future price tag of printing six trillion dollars' worth of checks comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold.

Investors should be alert to the long term inflationary thrust of such check writing. While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the 'out' years toward which long-term bond yields are measured. You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies.

When you combine these two themes, you get an interesting picture. As our current credit market is expanding at a rate of trillions per year, there has been very little real growth in the economy to show for it. As the government uses its printing press and quantitative easing policies, it further fans the flames. How long this situation persists is debatable, but the final result points to the creation of inflationary dragons, as presented by Gross.

Protecting Your Wealth

The question is: What can investors do to protect themselves against such events? Gross has once again presented some overarching concepts regarding to what to look for. Here are his recommendations as to what steps investors need to take:

1. Position for eventual inflation: the end stage of a supernova credit explosion is likely to produce more inflation than growth, and more chances of inflation as opposed to deflation. In bonds, buy inflation protection via TIPS; shorten maturities and durations; don't fight central banks -- anticipate them by buying what they buy first; look as well for offshore sovereign bonds with positive real interest rates (Mexico, Italy, Brazil, for example).

2. Get used to slower real growth: QEs and zero-based interest rates have negative consequences. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems. Australia, Brazil, Mexico, and Canada are candidates.

4. Transition from financial to real assets if possible at the margin: buy something you can sink your teeth into -- gold, other commodities, anything that can't be reproduced as fast as credit.

5. Be cognizant of property rights and confiscatory policies in all governments.

If you believe that such inflationary dragons and credit supernovas are destined to materialize, then the above strategies are very well thought out. Let's take a look at each in more detail, and try to suggest actual holdings that might be appropriate.

Treasury Inflation-Protected Securities

TIPS are securities sold by the U.S. Treasury that provide protection against inflation. The principal amount of TIPS increases with inflation, or can decrease with deflation based on the consumer price index. Interest is paid twice a year at a fixed rate. The rate is applied to the adjusted principal and, like the principal, interest payments rise with inflation and fall with deflation.

So what is the easiest way to invest in these financial instruments? One of the most popular is via exchange-traded fund iShares Barclays TIPS Bond (NYSEARCA:TIP).

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This holding seeks investment results that correspond generally to the price and yield performance of the Barclays U.S. Treasury Inflation Protected Securities Index (Series-L). The fund generally invests at least 90% of its assets in the bonds of the underlying index, and at least 95% of its assets in U.S. government bonds. The underlying index measures the performance of the inflation-protected public obligations of the U.S. Treasury. Net assets for this funds stand at $22.2 billion and has a current yield of 2.21%.

Many novice income investors will look at TIP's small 2.21% yield and write off this kind of investment. Sure, it's easy to find other more lucrative income investments with much higher yields, but the question is: Do they offer the kind of protection that TIP does? If the inflationary dragons do rear their ugly heads and interest rates rise, many traditional income investments will suffer badly. Asset values of those investments will fall as their income yields attempt to keep pace.

This is an environment where TIP will thrive. So while an investment in TIP might not be the greatest of income producers, it should prove to be an effective shield against Gross' dragons.

Moving Your Money Over the Border

The second recommendation was to move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems. Australia, Brazil, Mexico, and Canada were mentioned as candidates. At first, this sounds like a daunting task and a bit beyond most investors. Fortunately for us, we as investors have access to many current exchange-traded funds that track foreign currencies.

The candidates that were presented were an interesting mix, but I was most comfortable with the Canadian choice. Of course, arguments could easily be made for the other investments as well.

For this article, let's focus on Canada and its currency. Our friends to the North ran surpluses for about a decade, but in 2008 that all changed. As the global economic crisis spread, Canada slipped back into deficit spending and currently the national debt is over $600 billion. Although this is concerning, it really does not compare to what is happening with the United States and its debt issues. Taking all this into consideration, let's examine one way to access the Canadian dollar.

One investment to consider is CurrencyShares Canadian Dollar Trust (NYSEARCA:FXC).

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The trust was formed under the laws of the state of New York on June 8, 2006. FXC holds Canadian dollars and, from time to time, issues baskets in exchange for deposits of Canadian dollars and distributes Canadian dollars in connection with redemptions of baskets. The investment objective of FXC is for the shares to reflect the price in USD of the Canadian dollar. The primary purpose is for shares to represent a cost-effective investment relative to traditional means of investing in the foreign-exchange market.

The concept here is simple. The hope is that if inflationary times were to hit the U.S. dollar, having your wealth in a foreign currency might offer some protection. Holding currencies in countries that do not have crushing debt like the U.S. might safeguard one's wealth.

Buy Something You Can Sink Your Teeth Into -- Precious Metals

Obviously, precious metals -- like gold and silver -- will make lots of sense during inflationary times. Before we just agree to the concept, we need to find the investment vehicle that makes the most sense. There are several ways to invest in these metals, but actual control over the physical metal is probably best. A major concern that comes into play with holding the actual precious metals is storage and security. Holding precious metals dictates that you had better have the means to protect it. Theft will always be an issue, and the more one has, the harder it becomes to manage. Also, one must consider the possibility of confiscation as some point. Although this is unlikely, it has occurred in the past and will always be an option if events do spiral out of control.

That being the case, holding precious metals might not be the best option for everyone. A better approach might be to invest in a closed-end fund that primarily invests in commodities like silver and gold. One of the top choices is Central Fund of Canada Limited (NYSEMKT:CEF).

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This fund's purpose is to hold gold and silver bullion in the highest security rated vaults in Canada (outside the reach of U.S. confiscation). Currently, over 95% of the fund's assets are physical bullion. Below is CEF's current inventory of assets.

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CEF's shares trade on the open market like any other listed stock. That being the case, buying and selling shares is much easier than actual physical bullion transaction.

Before buying any closed-end funds, there are some issues to consider. Closed-end funds have their share price based on demand. That being the case, the shares can trade well above or below the net asset value of the holdings that make up the fund. It is a unique dynamic for closed-end funds and one characteristic that must be analyzed before one commits to buying in. Therefore, there exists the possibility that they will trade in a wide range with regard to the net asset value.

Buy Something You Can Sink Your Teeth Into -- Commodities

When it comes to commodities, one does not have to look much farther than the energy sector. The problem is that there is a plethora of equities to choose from in this sector. The trick is to make sure to get one of the best-run companies. I am going to sound like a broken record and suggest my favorite energy holding, Linn Energy (LINE).

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LINE is an independent company that engages in the acquisition and development of oil and gas properties. The company's properties are primarily located in the Mid-Continent, the Permian Basin, Michigan, California, and the Williston Basin in the U.S. Linn is a top 10 U.S. independent oil and natural gas company. The company focuses on the development and acquisition of long-life properties that complement its asset profile.

The question now is: Why choose LINE over so many others? The answer to this question is based on LINE's management style. Over the last year, energy prices have been volatile and many well-known companies have found themselves on the wrong side of the trade. LINE was not one of these companies, and the reason for that is its hedging program. It is this hedging program that puts investors' minds at ease and provides some stability in unpredictable markets.

LINE is approximately 100% hedged on expected natural gas production for six years through 2017. The expected oil production is 100% hedged for five years through 2016. For 2012, the company was hedged at a weighted average oil price of $97.26 per Bbl and a weighted average natural gas price of $5.28 per Mcf. Linn's reserve-life index is approximately 18 years.

Besides being a great inflationary defense, LINE is also a notable income generator for its shareholders. Since its IPO in 2006, the company has grown its cash distributions more than 81%, and has consistently paid its distributions for 29 quarters. Most recently, LINE announced a cash distribution for the fourth fiscal quarter of 2012 of $0.725 per unit, or $2.90 per unit on an annualized basis, for all of its outstanding units. The distribution will be payable Feb. 14, 2013, to unit holders of record at the close of business Feb. 7, 2013. At the time of this writing, LINE is paying a quarterly dividend rate of 7.5%.

LINE has also been very active on acquisitions for the company. Since the company's inception, there has been more than $10 billion in 54 separate transactions. Narrowing the time frame, we see that since December 2011, LINE has closed $3.4 billion in joint ventures and acquisitions. LINE is taking advantage of the current market prices and adding to its ever-expanding asset base. Needless to say, as new assets and their output come online, LINE will waste no time in hedging the new production.

LINE will release its fourth-quarter and full-year 2012 financial results in late February. That being the case, let's take a look at the company's third-quarter 2012 results to get a taste of how things are going. For that time frame, LINE increased its average daily production 106% to 782 MMcfe/d, compared to 379 MMcfe/d for third-quarter 2011. The adjusted EBITDA increased 65% to $402 million, compared to $243 million for third-quarter 2011. Finally, the distribution coverage ratio was calculated to be 1.40x, which means that LINE is generating more than enough cash to cover its current distribution to unit holders. Taking all this into consideration, LINE would be a viable choice for inflationary times that are predicted by Gross.

When investors think of commodities, their focus automatically turns to items like gold and energy. Sometimes, though, investors will also turn to the agriculture plays and concentrate on such objects as corn, wheat, and soy. The agricultural investments work off the theme that ever increasing populations, coupled with inflation, will see increases in food prices. If that is truly the case, then one possible inflationary play would be in fertilizer. If you feel this way, then CVR Partners, LP (NYSE:UAN) is definitely worth a look.

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UAN is a partnership formed by CVR Energy (NYSE:CVI) to own, operate, and grow the nitrogen fertilizer business. The nitrogen fertilizer manufacturing facility is located in Coffeyville, Kan. It is the only such operation in North America that uses a petroleum coke gasification process to make hydrogen, a key ingredient in its manufacturing process. UAN produces about 5% of the total urea ammonium nitrate demand in the United States.

Fiscal-year 2012 was a challenge for UAN. The company's production was held back by a planned turnaround, plus a plant expansion project that is scheduled to come into play by March 2013. As we wait for fourth-quarter reporting figures that will be released in late February 2013, let's look at UAN's third-quarter production totals. For the third quarter of 2012, CVR Partners produced 104,200 tons of ammonia. Of that total, 29,400 net tons were available for sale while the rest was upgraded to 181,900 tons of more profitable urea ammonium nitrate. In the 2011 third quarter, the plant produced 102,700 tons of ammonia with 25,900 net tons available for sale. The remainder upgraded to 185,800 tons of urea ammonium nitrate.

When looking at the financial aspect, we see that UAN had third-quarter 2012 net income of $31.6 million on net sales of $75.0 million. For the third quarter of 2011, the net income was $36.3 million on net sales of $77.2 million. For the nine-month period, the net income was $96.9 million on net sales of $234.7 million. This was an increase when compared to $91.2 million of net income on net sales of $215.3 million for the comparable period a year earlier.

The key to UAN is its expansion project. Management hopes to increase urea ammonium nitrate production capacity to more than 3,000 tons per day. After a noted delay, UAN projects the expansion to start up in early March 2013. This delay is anticipated to impact 2013 full-year cash available for distribution by approximately 5 cents per common unit. While this is not good news, the company continues to expect a significant double-digit increase in cash available for distribution for full-year 2013 as compared to 2012.

In 2013, UAN's management is expecting a continuation of higher prices in fertilizer, as well as growing demand for its products. Population growth and severe drought conditions on the corn crops will also prop up UAN's business model for some time to come. In an inflationary environment, UAN should be one stock to own.

Conclusion

In conclusion, inflation has yet to appear in the economy. Only time will tell if Gross will be proven right, but his predictions seem very plausible. The real question is: Will investors be ready if the inflationary dragons do finally make their appearance?

Disclosure: I am long UAN, LINE, TIP, CEF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.